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We were wrong: IMF report details the damage of austerity

From The Conversation comes the below article on the IMF’s recent about-face on fiscal austerity. The author, Remy Davidson, is Jean Monnet Chair in Politics and Economics at Monash University.

In a rare volte-face, the International Monetary Fund this week admitted that it grossly underestimated the impact of the austerity regime it advised Europeans to adopt.

A paper authored by IMF chief economist Olivier Blanchard found that every dollar that governments cut from their budgets actually reduced economic output by $1.50.

The IMF forecast originally that economic activity would be reduced by only $0.50 for every $1.00 fiscal spending cut. Now this is not the IMF’s official position, mind you. But Blanchard, as chief economist, makes the IMF look shame-faced. Indirectly, at least.

Predictably, this has given considerable ammunition to critics of the bitter austerity prescription that has characterised European governments’ fiscal policies.

Economics is known as the dismal science. But for the IMF’s critics, this egregious forecasting error — upon which so much policy advice was built — is more than a crime. It’s a mistake.

The fact is that economics is much more of an art than a science. Econometricians can factor in x amount of data into a model to show outcome y. Like actors, who are only as good as their scripts, economists are only as good as the data they input.

Go forth and multiply

How did the IMF get it so wrong? Multipliers. Specifically, the wrong ones.

Although the 18th-century physiocrat, Quesnay, formulated the basis of multipliers in economics, John Maynard Keynes is generally credited with the conceptual modernisation and application of the “multiplier effect”. Briefly, every dollar that’s spent increases aggregate demand, as that same dollar is spent again and again and again. It’s this fiscal multiplier that the IMF employed to measure the likely effect of budgetary spending cuts.

Fawlty forecasting

To understand multipliers, here’s a brain teaser for you. Imagine we’re in the 19th-century equivalent of Fawlty Towers.

His Lordship arrives at a hotel and requests a room.

“Certainly, m’lord,” replies the manager.

But the man wants to see the room first. He puts his coat in the cloakroom and goes upstairs to take a shufty. While he’s gone, the manager steals £5 from his wallet. He then runs down the street and pays off the, er, lady of the night, to whom he owes five quid.

Said lady then hoofs off to the butcher’s to pay off her £5 worth of sausages. The butcher, in turn, heads over to the baker, where his account is in arrears to the tune of a fiver. The baker pays his £5 to the milkman. And the milkman heads to the hotel to pay the manager the £5 he owes on the room he rented there the last time he met up with the shady lady.

Then the manager replaces the £5 he stole from the toff’s wallet. His Lordship decides the room is not at all like Hampton Court Palace and leaves.

So, goods were produced. Services were rendered. Debts were paid. There were economic outputs. GDP — in theory — increased. And all due to one lousy £5 note. That’s a multiplier for you.

One more thing: in all instances, credit was extended. You could consider the aristocrat the government. Or a bank. Except, unlike governments, banks don’t give away money; they rent it out.

Meanwhile, back at the IMF…

Blanchard calculated that the IMF utilised a multiplier of 0.5. In reality, it should have been 1.5. In the IMF’s defence, Blanchard argues that the Fund underestimated the extraordinary financial circumstances of the European economies. In other words, the IMF was too optimistic about the impact of austerity measures upon GDP, and did not expect the effect upon unemployment would be so severe.

In a sharp response to critics, Blanchard’s report also notes that: “Some commentators interpreted our earlier [findings] as implying that fiscal consolidation should be avoided altogether. This does not follow from our analysis. The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy.”

In other words, Blanchard doesn’t find that fiscal consolidation is the incorrect prescription, but that individual economies need to find the correct policy mix to ameliorate the worst effects of fiscal discipline.

Casino capitalism

Blanchard’s paper shows that the OECD, the EU and the Economist Intelligence Unit all got their forecasts wrong. The IMF was just – well – even less accurate.

But that merely reinforces the point that economics is an art. But a black art, rather than a bad art. Consider the Reserve Bank’s last three interest rate cuts: did you pick them? How about the Australian dollar exchange rate over the last quarter? Or Apple’s share price?

If so, what are you doing here? Why aren’t you playing the global casino? You should have five Bloomberg screens in your living room, a pile of cash a kangaroo couldn’t jump over, and a super-yacht in Antibes.

The difference between private firms and international organisations such as the IMF is that the Fund is not attempting to profit from its forecasts. More accurately, it makes policy prescriptions and offers technical advice. In this instance, it recommended fiscal consolidation.

Now, I fully expect the harbingers of austerity doom (Krugman et al ) to come out of the woodwork any minute now, although they have not been returning phone calls since the Eurozone failed to implode, as predicted. And, despite serious, long-term problems, Greece has not departed the Eurozone either. This prediction by Citigroup in 2012 should leave you rolling in the aisles:

“Greece WILL leave the eurozone on January 1, 2013.”

About as accurate as a Mayan calendar.

More seriously, the anti-austerity advocates appear to have no real concern for the longer-term consequences of indebtedness. At a certain point, fiscal deficits and sovereign debt become structural (the deficits and debts cannot be eliminated without profound alterations to the structure of public spending, borrowing, the balance of payments and the taxation base).

A return to first principles

A cornerstone of good governance should be a commitment to sound fiscal outcomes. But something happened on the road to sound credit and responsible fiscal policy. Does anyone seriously argue that increasing fiscal deficits and ballooning sovereign debt is not the road to serfdom? By maxing out your credit cards, you are merely postponing the inevitable day of reckoning (yes, I know Washington does nothing but debt, but the US is in a unique position).

True, there is clearly a role for governments to intervene to boost demand via deficit spending during periods of recession. That’s long been the Keynesian prescription.

But most governments ignore the other half of Keynes’ sage advice: namely, saving fiscal surpluses during periods of prosperity to ensure fiscal stability during recession, even as the public sector borrowing requirement increases. And not squandering precious surpluses on pink batt programs (Australia), moat-cleaning (Britain), Facebook-addicted civil servants (“Facebook: it’s French for Work”), and middle-class welfare, corporate welfare, farm welfare and subsidised property bubbles (everyone).

The problem is not liquidity

Austerity be damned. We are still absolutely awash with liquidity. There is more than adequate liquidity in the global financial system at present. The US Fed’s QE3 program will add another $US1 trillion to the debt coffers.

But there’s liquidity – and there’s credit. It’s just that financial institutions aren’t investing in anything other than blue chips and A-rated bonds. Global venture capital plunged 33% in 2012, a disastrous result on the back of a weak 2011. By contrast, global M&A was up in 2012.

Forget IMF forecasts. The crux of the problem remains the vulnerability of the global financial system and its reluctance to lend freely, exacerbated by the fact that global interest rates, for the most part, remain too low to warrant risky lending.

And there’s bad news and worse news. It came out of Basel early this year, courtesy of the Bank for International Settlements (BIS). The much-trumpeted Basel III accord, which sought to place banks’ underlying cash and short-term asset base on a much firmer footing, has been watered down and delayed. Instead of blue-chip assets, financial institutions will be able to maintain or increase their leverage and fractional reserve lending using much lower-quality assets – like those dreaded mortgage-backed securities — that got us all here in the first place.

Comments

When have the IMF ever been right ? this has to be the dumbest group of people on the planet and I have no idea why anyone would believe a single thing coming from them. The EU is a sheet of glass and the IMF is a wrecking Ball.

What bskerr2 says is true. However it is possible that the IMF knowingly misled everyone so that politicians would vote to give Greece more money. I.e. the IMF provided cover for the bailouts and for the Greek govt to decimate Greek living standards.

No one is that dumb, especially the best economic minds on the planet. There is a reason why they acted in the way they did – to provide cover for politicians so they could take money from the taxpayers of Europe on the myth of a Greek recovery.

“Does anyone seriously argue that increasing fiscal deficits and ballooning sovereign debt is not the road to serfdom?”

To answer your question, yes. They will be along shortly.

I would venture that the reason why the multiplier is 1.5 ish and not the lower forecast of .5 is because the IMF, for some unknown (political) reason understated the netted roles certain Euro Govts play in their economies. Meaning to say that it is far too great, hence the higher actual multiplier effect of their spending.

(Over) SPENDING begetting Debt is the root cause of their dilemna. The solution must include placing strict, realistic and sensible limits on spending while reducing Debt. Painful for many, yes. But it offers a future out of serfdom hopefully.

The Fed is indemnifying the Banks through the public means available. In effect, the Fed is covering the costs to Banks of dodgy homeloans. Thats not the real issue, even though it is substantial. The hole left on Bank off-balance sheet items from their derivative implosions still remains. Reportedly Trillions in downgraded paper. They had to alter existing accounting rules that allow them to mark those “assets” to make believe to get around it- for now. The can kicking QE has to continue.

Well said UE!
Put this bit up in lights
“More seriously, the anti-austerity advocates appear to have no real concern for the longer-term consequences of indebtedness. At a certain point, fiscal deficits and sovereign debt become structural (the deficits and debts cannot be eliminated without profound alterations to the structure of public spending, borrowing, the balance of payments and the taxation base).”

They also take no account of the resulting indebtedness in the external account which cannot be repaid by printing bits of paper or minting a Trillion dollar coin!

More seriously still the negative RAT interest rate credit binge of the last 30 to 50 years has created all sorts of terrible distortions in our economies. We massively overpay non-productive sectors and underpay productive. More importantly still our social structures are screwed, our education system totally out of whack with reality, and our own sense of entitlement exaggerated.
This easy credit period has damaged our basic psyche.

Thanks MJV….and yes it is rare to see such good sense come out of any university let alone Monash! I am truly surprised. Almost everything else i’ve read that comes out of universities lately is absolute twaddle….except for Rumples!

The error is the models, the assumptions and the failure to understand the difference between currency sovereigns and currency users.

If not, mainstream economics would have:
1. Foreseen the GFC
2. Understood that austerity during a balance sheet recession in the private sector would lead to recession.

Bill Mitchell highlights a few of the major errors in assumptions like:
All countries can all export their way out of trouble at once, even if there is a virtually universal slowdown in demand. It works for one or two countries if the rest of the world has growth and is facing capacity constraints, but not when virtually all have heightened unemployment and savings rates.

“Does anyone seriously argue that increasing fiscal deficits and ballooning sovereign debt is not the road to serfdom?”

As S.Keen and others have pointed out is it private debt that is the issue (outside of Europe).

It is remarkable that whoever this author is doesn’t express the same degree of hand wringing about external deficits. Lord Kaldor summed it up perfectly 30 years ago:

“If a large trade deficit is continued long enough it would involve transforming a nation of creative producers into a community of rentiers increasingly living on others, seeking gratification in ever more useless consumption, with all the debilitating effects of the bread and circuses of Imperial Rome”

That quote is also worth reflecting on when reading the recent article on the bloggosphere about mercantilism vs liberalism.

I havent had a good opinion about the IMF since the Asian crisis in 97. Malaysia’s PM summed it up when he rejected their advice stating that it wasnt in Malaysia’s best interest as a sovereign nation. Mathahir was a smart cookie though

“So, goods were produced. Services were rendered. Debts were paid. There were economic outputs. GDP — in theory — increased. And all due to one lousy £5 note. That’s a multiplier for you.”

Er no actually NOTHING was produced in this example. The net addition to GDP was zero. All the goods and services had already been produced / provided for and been put on credit (just because its not provided by a bank doesn’t mean its not credit).

All his example shows is how credit can allow those without enough presently available funds to consume and borrow against future earnings capacity.

“Forget IMF forecasts. The crux of the problem remains the vulnerability of the global financial system and its reluctance to lend freely, exacerbated by the fact that global interest rates, for the most part, remain too low to warrant risky lending.”

What a load of rubbish.

The problem is not low interest rates. Nothing stops a bank extending credit at rates massively above those paid by risk free entities to account for the risk of loss (see the booming pay day lending businesses in the UK as an example).

The problem is that there is no demand for credit from the private sector in the eurozone.

Why would a consumer borrow when their job is under threat and asset prices are falling? Why would a business borrow if its sales and output is falling?

More to the point apart from Greece the issue in the PIIGS was not government debt but private debt. This debt was built up due to the massive current account deficits caused by their entry into a monetary union without fiscal union.

At the heart of the matter Europe still needs to resolve its current account imbalances between the north and the south. It is absolutely clear that the internal devaluation in the south they have pursued through austerity is not working. e.g. Greece’s current account deficit is still almost 10% of GDP!

“Why would a consumer borrow when their job is under threat and asset prices are falling? Why would a business borrow if its sales and output is falling?”

Isn’t it remarkable that these people can’t even see such a simple thing? That’s supply-side economics at work for ya. When the whole edifice of the frame work is crashing down on them, they still assert that it’s because of that damn low interest rate, proving that they have learned nothing from Japan, and nothing from this crisis.

“Now, I fully expect the harbingers of austerity doom (Krugman et al ) to come out of the woodwork any minute now, although they have not been returning phone calls since the Eurozone failed to implode, as predicted.”

Except that “Krugman et al” don’t have to “return phone calls” at all. Their main argument was that the euro zone would disintegrate sooner than later if the central bank doesn’t show any will to backstop the bonds. Draghi did that in 2012.

And their main concern was that the economies, particularly in the periphery, would remain depressed, with sky-high unemployment, for years to come on the current path. Have we gotten any sign of recovery on that front?

You are just putting your words into someone else’s mouth, creating a phantom “enemy” to laugh at. That doesn’t work, man.